Gold and Fed Rate Hikes

Gold's sharp early-year surge has fizzled in recent weeks as investment demand
faded. The primary reason is the universal belief that the Fed's upcoming rate
hikes are very bearish for gold. Higher rates will make zero-yielding gold
relatively less attractive, argues this popular thesis. But history proves
just the opposite. Gold actually thrives in rising- and higher-rate environments,
so rate hikes are nothing to fear.

This notion definitely seems counterintuitive today. When the Fed finally
begins letting interest rates start to normalize after actively suppressing
them for years on end, yields on bonds and cash in the form of money-market
funds will rise. That will make these asset classes more appealing to investors.
So they will migrate out of gold, which yields nothing, into the new higher-yielding
bonds and money-market funds.

This logic is simple, which is why the great majority of investors and speculators
today believe that gold is going to face relentless selling as rates rise.
But rather than accepting this conventional "wisdom" at face value, why not
see what's happened in the past? Did the earlier periods of rising and higher
rates suck vast amounts of capital out of gold, deflating its price? If not,
then this popular thesis is dead wrong.

It's funny how ideas take root and flourish in the financial markets. Traders
are highly emotional, with most of their trading decisions based on greed and
fear. They also have an overwhelming status-quo bias, expecting current
market conditions to persist indefinitely. Thus any rationalization of why
stock markets will rally on balance forever while gold fades into oblivion
are quickly seized on and trumpeted as truth.

With traders' collective greed and fear constantly overriding their rationality,
popular fallacies always exist. They include widespread beliefs today that
market history proves are ridiculous. Such as the ideas that stock markets
can rally perpetually without corrections or bears, that stock-market
valuations don't matter, and that central banks can successfully manipulate
prices forever. History makes a mockery of these!

Yet traders believe what they want to, whatever seems to bolster their views
that existing trends have turned permanent in some new era. But the past record
is crystal-clear, financial markets are forever cyclical. Asset classes
rise as they grow popular, but then inevitably subsequently fall as they drift
out of favor again. Gold is no exception. Gold can't drift lower forever any
more than stock markets can rally forever.

So instead of just blindly accepting today's belief that the Fed's rate hikes
are bearish for gold, why not check the historical record? This first chart
includes over 45 years of daily gold-price and interest-rate data. For
interest rates I used the yields on benchmark 1-year Treasury bills and 10-year
Treasury notes to represent both the short and long ends of the yield curve.
Are rising and higher rates really bearish for gold?

The simple answer is absolutely not. Gold's mighty secular bull of the 1970s,
which greatly dwarfed the 2000s one, happened during a time of high and
rising interest rates! And then gold's subsequent multi-decade secular
bear in the 1980s and 1990s unfolded during a long span of interest rates relentlessly
falling on balance. Gold rallying with rising rates and slumping with falling
rates? That's not in the script.

And over this chart's entire nearly-half-century span, gold and interest rates
were actually not highly correlated at all. While gold indeed had the negative
correlation with rates that many today expect, it was actually very weak. Gold's
correlation r-squares with 1-year and 10-year Treasury yields ran merely 29%
and 28% respectively between 1970 and 2015. For all intents and purposes, this is
essentially uncorrelated.

Mathematically, only well under a third of gold's daily price action
was directly explainable by short- or long-term interest rates. This wouldn't
be the case if higher rates made gold far less attractive to investors and
vice versa, so today's popular thesis about gold and rates is simply false
historically. Actually well over two-thirds of the gold-price action in our
lifetimes had nothing to do with the changing interest rates!

Like all other prices, gold's are driven by global supply and demand. And
since it takes over a decade to advance a deposit into an operating mine, gold's
supply changes very slowly. All the real fundamental action in the yellow metal
comes on the demand side. And the big wildcard on that half of the equation
comes from investment demand, which can fluctuate massively at the margin.
It drives all gold's big moves.

So interest rates could only affect gold through investment demand. Today's
traders believe rising and higher rates retard gold investment demand as investors
shift capital to higher-yielding bonds. But they have a monumental historical
problem in the form of the biggest secular gold bull of our lifetimes. Back
in the 1970s when gold skyrocketed over 24x higher in nominal terms, it actually
moved with interest rates!

Way back in March 1971, short rates as represented by 1-year T-Bill yields
bottomed at 3.5%. And by October 1979, they would nearly quadruple to
13.6%! Now no one today even thinks the Fed hiking the Federal Funds Rate it
directly controls to double-digit ranges is even possible. So there is truly
no more extreme example than the 1970s to reveal how rising and higher rates
affect gold investment demand.

And obviously gold bucked today's consensus and soared right alongside interest
rates! It actually had very high positive correlations with 1-year and
10-year Treasury yields, enough to generate very strong r-squares of 64% and
83% respectively. So from two-thirds to over four-fifths of gold's bullish
upside price action between 1970 and 1980 was directly mathematically explainable
by the rising interest rates.

Gold was actually strongest when the short-term interest rates utterly dominated
by the Fed Funds Rate were rising the fastest. Note gold's giant spikes in
1973 and 1974 as rates soared in direct response to Fed rate hikes. And then
gold actually slumped in 1975 and 1976 as interest rates fell, which again
flies in the face of what traders expect today. Then it soared again in 1978
and 1979 as rates skyrocketed.

So in the biggest secular gold bull of our lifetimes by far, rising and higher
rates were as far from being bearish for gold as they can get. Just the opposite
was true, the faster the rate hikes and the higher the rates went, the more
investment demand for gold soared! This relationship only seems counterintuitive
today because traders' status-quo bias has temporarily blinded them to normal
cyclical market behavior.

Rising and higher interest rates are actually bullish for gold for one simple
reason. And that is they are actually very bearish for stocks and bonds.
Gold is an alternative asset that shines the brightest when the conventional
asset classes are suffering. And nothing pummels stock and bond markets like
rising interest rates. That is the sole reason the Fed has been so darned slow
in normalizing interest rates!

Rising and higher rates hit the stock markets in a variety of ways. They make
bond investing relatively more attractive for stock capital. In periods of
low interest rates, bond investors are often forced into the stock markets
to chase yields. But they never like being there, as stocks paying healthy
dividends are always at risk of seeing major price declines. There is essentially
zero principal risk in bonds held to maturity.

So as rates rise, the bond investors grudgingly holding stocks exit to migrate
back into their favored asset class. Since the pools of bond-market capital
are so vast, this selling pushes the stock markets lower. Rising and higher
rates also make stock markets look more overvalued in several ways.
When bond yields are higher, investors are far less willing to pay high prices
in price-to-earnings-ratio
terms for stocks.

So the lower demand won't support overvalued stock markets, and they sell
off. The higher rates also directly hit corporate profits, which further erode
valuations. Companies' debt-servicing expenses rise with rates, reducing earnings.
And their customers also face the same higher borrowing costs, so they buy
less which dampens corporate sales. And lower sales also naturally lead to
lower profits of course.

When stock markets start flagging significantly, which rate hikes usually
ensure, investors start flocking to alternative investments led by gold
that thrive when general stocks are weak. The reason that gold rocketed 186%
higher in 1973 and 1974 despite 1-year Treasury yields climbing from 5.7% to
7.4% with far-higher 9.2% and 10.0% rate spikes within this span was the S&P
500 plummeted by 42% during it!

Rising and higher rates crushed stock markets, so gold investment demand
exploded as a safe haven that wouldn't get sucked into the stock markets' downside
maelstrom. And conversely when the S&P 500 rebounded out of its 1973-1974
cyclical bear to soar 57% higher in 1975 and 1976, gold plunged 28% despite
short rates falling from 7.4% to 4.9%. The stock-market fortunes were
the key to gold in the 1970s.

And they still are today. The only reason gold plummeted in 2013 on epic extreme GLD-gold-ETF and gold-futures
selling was because the Fed's radically-unprecedented open-ended third
quantitative-easing campaign and associated jawboning catapulted
the general stock markets far higher. When conventional investments are
surging, investment demand for alternatives naturally fades away to nothing.

The Fed's artificial prolonging of this latest cyclical stock bull with
extreme money printing is the sole reason gold fell so deeply out of
favor in the past couple of years. But these lofty Fed-goosed stock markets
are long overdue to roll over into the next cyclical bear, and when that
happens gold will shine as investors again seek out alternative investments.
The Fed's rate hikes will accelerate this process.

The benchmark S&P 500 has soared an astounding 209% higher in 5.8 years
as of late December, far beyond the average ranges of normal cyclical bulls.
Its elite component stocks were trading at a nearly-bubble-level average
trailing-twelve-month price-to-earnings ratio of 25.1x at the end of
last month! And it's been a staggering 3.4 years since the last stock-market
correction exceeding 10%. A major selloff is inevitable.

And whenever it happens, gold will catch a huge bid regardless of what
interest rates are doing. Again the only reason the Fed has kept its
risky and asinine zero-interest-rate policy in place since December 2008
despite the soaring stock markets and improving jobs picture is because it
is rightfully terrified of what rate hikes will do to these wildly-overextended
stock markets. But it will soon have to act regardless.

Fleeing into bonds isn't a great option for stock-market capital either, as
rising and higher rates are even more devastating for bond markets. Bonds are
debt contracts with yields fixed at issuance, yet those yields have
to trade at current prevailing rates. So as rates rise, bonds are sold until
their prices fall low enough for their fixed payments to equal current
yields. This means big principal losses for investors.

Long-term investors can hold bonds to maturity to avoid the inevitable mid-term
principal losses. But this is a tough bet to make, since new bonds are always
coming out in rising-rate periods with higher yields. This makes bond investing
an utter minefield when the Fed is hiking rates, an unforgiving realm that
makes capital appreciation very difficult for even the best traders. Gold can
be much more appealing.

If investment capital is flowing into gold due to rate hikes' serious adverse
impact on stocks and bonds, investors in both are attracted to its high returns.
When gold is rallying while both stock and bond prices are falling, the gold
investment demand grows dramatically and feeds on itself. So contrary to popular "wisdom" today,
rising- and higher-rate environments are super-bullish for gold investment
demand.

This final chart looks at gold and the benchmark Treasury short and long rates
during the last secular gold bull of the 2000s. While neither gold's bull run
nor the interest-rate cycles were anywhere near as extreme as in the 1970s,
they still prove how wrong today's universal belief is that Fed rate hikes
are bad news for gold. Gold actually soared during the Fed's last rate-hike
cycle, and thrived in much higher rates.

It is true that interest rates meandered lower on balance during gold's last
secular bull. As gold blasted 7.4x higher between April 2001 and August 2011,
1-year and 10-year Treasury yields plummeted by 98% and 58% respectively. But
it wasn't the Fed-imposed artificially-low interest rates that drove this latest
gold bull. Gold peaked fairly early in the Fed's ZIRP campaign, and well before
10-year yields bottomed.

And that entire massive gold bull happened in a far-higher rate environment than
today's. Over its long 10.4-year span, 1-year and 10-year Treasury yields averaged
2.2% and 4.1%. These are way higher than today's prevailing yields, 10.2x and
2.0x respectively. If gold enjoyed such incredible investment demand at these
far-higher yields than today's, then why are Fed rate hikes back up to these
same levels bearish?

Obviously they're not. But today's emotional investors and speculators want
to irrationally believe the Fed's conjured fiction of stock markets rallying
forever. So they always look to rationalize their status-quo bias, to
latch on to any thesis, no matter how flimsy, if it supports their worldview.
And that is today's absurd belief that financial markets are no longer cyclical,
that stocks rally forever while gold slumps forever.

Why succumb to this dangerous groupthink instead of simply consulting the
historical record? If Fed rate hikes are bearish for gold as everyone assumes
these days, then it must have been pounded in the last major rate-hike cycle.
That happened between June 2004 and June 2006, a two-year span where the Fed more
than quintupled its Federal Funds Rate from 1.00% to 5.25%. Did gold utterly
collapse?

Not so you'd notice. Over the exact span of that last major Fed-rate-hike
campaign, from FOMC day to FOMC day, gold blasted 49.5% higher! Its young secular
bull actually accelerated dramatically while the Fed was aggressively
raising rates. Since rising and higher rates make stocks and bonds look a lot
less attractive and a lot more overpriced, alternative investments led by gold
return to favor. Don't forget that.

Today's universal belief that the Fed's next rate-hike cycle is bearish for
gold is total garbage. It just blows my mind that anyone actually believes
it. How can anyone be so foolishly susceptible to herd groupthink that they
can't spend a couple hours studying gold's actual reactions during past rising-
and higher-rate environments? If rate hikes are bearish for gold, then it would
be readily apparent in historical data.

Gold's latest woes were exacerbated by last Friday's big upside surprise on
the US monthly jobs report. It ignited heavy gold selling that ultimately pounded
the metal down 2.4% that day alone. Why? Because the better-than-expected jobs
read led gold-futures traders to think the Fed's rate hikes are going to start
sooner rather than later. And these naive speculators chose to believe rationalizations
instead of history.

Just like in the past, the inevitable upcoming Fed rate-hike cycle is going
to be super-bullish for gold. The rising and higher rates are going to hammer
these lofty, overvalued, and overextended stock and bond markets. And that
will lead prudent investors to seek alternatives, places to park their capital that
move inversely to stocks. There's zero doubt gold investment demand will
surge during the coming rate hikes.

And since gold investment demand on the margin determines gold prices, the
yellow metal will soar too. You can ride it higher in physical gold coins or
the flagship GLD
gold ETF. And if you want to leverage gold's coming gains as the Fed pricks
its own stock-market bubble, the beaten-down
gold stocks will greatly outperform gold to the upside. Only brave
contrarians fighting the crowd now will maximize their gains.

Because of all the popular falsehoods plaguing the markets today like this
gold-and-rate-hikes one, it's never been more important to cultivate an excellent contrarian source
of information. That's what we do at Zeal. We've long published acclaimed weekly and monthly subscription
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of hard-won experience, knowledge, wisdom, and ongoing research to explain
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With big changes afoot, you need to subscribe
today. Transcend the false groupthink to thrive!

The bottom line is contrary to the popular belief today, rising- and higher-rate
environments are actually very bullish for gold. Rather than making a zero-yielding
asset look relatively less attractive, rate hikes serve to hammer conventional
stock and bond markets. This leads investors to seek alternatives that rally
in times of general-stock weakness. And gold has always been the leading safe-haven
investment.

This was certainly true during the epic rate hikes of the 1970s, where gold
soared when the Fed was the most aggressive with its extreme rate hikes. And
it was also true during the Fed's last major rate-hike cycle of the mid-2000s,
when short rates more than quintupled yet gold still surged. And gold is set
to defy today's silly universal groupthink delusion and power higher again
in the coming Fed rate hikes.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

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and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
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